The Optimality of Loss Leading in Multi-Product Retail Pricing - A Rationale for Repealing the 1987 Groceries Order in Ireland

JEL Classification K21

Patrick P. Walsh and Ciara Whelan

Department of Economics, Trinity College, Dublin 2, Ireland.

Abstract

The Competition Act in 1991 repealed all legally binding Orders in Ireland except for the 1987 Groceries Order. Article 11 of this Order categorically prohibits retail pricing in the grocery sector below the net invoice price of the wholesaler or manufacturer. The vast range of products retailed through outlets and the convenience of 'one stop' shopping result in imperfect costumer information and consumer switching costs. This enables retailers to price below cost on Known-Value-Items (KVIs) to attract customer entry and subsequently impose higher price-cost mark-ups on other non-KVIs, a practice defined as loss leading. This practice was deemed to be essentially predatory in effect by the Fair Trade Commission (FTC) in 1987. In this paper we examine the potential legitimacy of below cost selling by modeling the optimal pricing of a multi-product retailer in a game-theoretic framework. We show that loss leading is an equilibrium outcome that is socially desirable in an imperfectly competitive market. We also model the repercussions of introducing the ban for equilibrium profits, corresponding services and concentration levels in the market. Our analysis suggests that a removal of the ban in favour of the 1991 Competition Act would be welfare improving.

Acknowledgements

Certain aspects of this paper were presented to seminars in Trinity College, Dublin and to the Irish Economic Association in May 1995. We thank all participants for their comments. We are also grateful to John Fingleton, Francis O'Toole, and Eric Strobl for their helpful suggestions and support.